Cyprus challenge to eurozone will continue, suggests Arbuthnot’s Ruth Lea

Ruth Lea, economic adviser to the Arbuthnot Banking Group, sees Cyprus continuing to play the role of a thorn in the Eurogroup’s side, amid ongoing concerns over the pace of eurozone economic recovery.

There were signs last year that the collective institutions of the eurozone appeared to be progressing towards the necessary institutional developments in order to hold the currency bloc together. Last summer’s existential threat to the euro area had seemed to focus minds. In particular moves towards banking union seemed promising, not least of all the agreement at the December summit to establish a “Single Supervisory Mechanism” (SSM).

Under the SSM the ECB will become the supervisor for the Eurozone’s biggest banks in 2014. Such apparent progress was, however, dealt a severe blow by the confused handling of the Cyprus bailout. An initial set of proposals (agreed on 16 March) unwisely involved imposing a levy on insured bank deposits (up to €100,000). This proposal triggered a wave of concern that such deposits in other banks, especially in the other peripheral Eurozone countries, would be vulnerable to similar levies. And amidst popular outcry there was much speculation about Cyprus’s exit from the eurozone. ECB president Mario Draghi spoke for many when he said “…that (the levy on insured bank deposits) was not so smart, to say the least, and was quickly corrected”.

A second set of bailout proposals was agreed on 25 March by the Eurogroup, comprising the eurozone’s finance ministers and presided over by Dutch finance minister Jeroen Dijsselbloem. The agreement broadly comprises:

   – Cyprus will be loaned €10bn including €1bn from the IMF (UK share €50m), leaving the eurozone to find €9bn which will probably come through the European Stability Mechanism (ESM). The loan will be repayable over 12 years and will probably be approved by Eurogroup by mid‐April.

   – The Laiki Bank will be wound up and its bad loans will be transferred to a “bad bank”. The rest of its balance sheet will be transferred to the Bank of Cyprus, which will also be restructured.

   – Savers with accounts below the €100,000 deposit guarantee threshold will be spared from levies but other creditors, including uninsured depositors with more than €100,000, will face significant losses. The banks will be “bailed‐in” by the creditors, rather than be “bailed‐out” by taxpayers.

   – The deal allowed Cyprus to use capital controls, now imposed, to stop deposits fleeing the banks. The single currency is now not so single. A central tenet of the Single Market is the four freedoms of goods and services, capital and labour.

The Cyprus bailout has political implications for the eurozone’s future, way beyond its economic significance. Cyprus’s GDP was less than €18bn in 2012 and it represents less than 0.2% of the eurozone’s GDP. European policy‐makers are arguably under‐estimating the extent to which events in Cyprus may yet destabilise the rest of the eurozone.

Central to the debate on the future of the eurozone remains the continued willingness of the northern creditor nations (focussing on Germany, but not only in Germany) to funnel funds to the peripheral countries. Popular resistance appears to be intensifying. Suffice to say such resistance is especially pertinent politically in a year of key Federal German elections (due on 22 September
2013). Heady ambitions to hold the eurozone together are colliding with political reality and electoral timetables.

More specifically Eurogroup’s Jeroen Dijsselbloem made it rather clear that, in his view, the Cypriot deal represented a “template” for any future bank rescues. If banks fail, then shareholders, bondholders and depositors can be expected to pay the bill not the taxpayer. The principle of moral hazard has been re‐established. The markets, reacting to the implications for banks in other weak peripheral eurozone countries, took fright. Dijsselbloem quickly repudiated his “template” statement, claiming that the Cypriot deal was, after all, a “one‐off”, but it is difficult to be convinced by this rapid “U‐turn”. The cat appears to have been let out of the bag. However much Dijsselbloem may protest about what he really meant, the Cypriot bail‐in serves notice on creditors of weak banks throughout the eurozone. Other eurozone heavyweights waded in to deny the “template” model. Mario Draghi, for example, recently stated that Cyprus’s deal was “no template” in order to ease market fears.

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